Undervalued stock of the week - Ausdrill

March 15, 2013, 11:44 amJohn AbernethyYahoo7

For those not afraid to take on some risk, this mining company represents a very fair risk/reward proposition.

John Abernethy is the Chief Investment Officer of Clime Investment Management (Clime). John has 30 years experience in funds management and corporate advisory services. His common sense approach to investing and forthright opinion has earned him a loyal following of Investors.Full Bio »

It's getting harder to spot mining companies that are priced at what we believe is a discount to their fair value, especially if you’re after those involved primarily in mining production instead of exploration – the latter of course being a far more risky proposition.

Ausdrill, however, is an established, well diversified and profitable mining services company, with operations in Australia and Africa. It has 19 separate business divisions offering almost every conceivable service to mining operations, and it offers the potential for substantial gains if it continues to perform as well as it has in recent years.

Ausdrill offers a everything from drilling, rig design, drill and blast services, equipment hire, earth moving, logistics to oil and gas well servicing – even the design, drilling and installation of telecom and underground power networks.

As a result it is winning increasingly large contracts which, while obviously good news, has the adverse effect of forcing the company to spend ever increasing amounts of money on property, plants and equipment in order to fulfil its workload.

Ausdrill has therefore become a capital-intensive business. Indeed, one of the things we think is keeping its price down is the fact its borrowings have increased to fund this expansion; its debt to equity ratio has risen to nearly 62 per cent – way above the management’s desired maximum level of 50 per cent.

However, it is important to remember that this gearing has helped the company deliver consistent profits growth over the past 10 years and succeed with exciting contracts such as the newly won, five year $540m contract from Resolute Mining Ltd.

In short, winning big business is not cheap, requiring big investments in order to derive longer-term gains, and that has meant borrowing and capital raisings – a fact the market does not appear to like.

However, we are backing the company because this strategy has worked well so far and the management is also likely to bring down the debt level as soon as it can.

The company has proved skilful in achieving a good return on its investments, with a normalised return on equity averaging 19.5 per cent over the past decade, compared to a market average of 14 per cent.

Going forward, forecasts suggest that ASL will continue with more of the same, achieving a return on equity of 19 per cent a year for the next three years, although this is subject to a range of factors including commodity prices, the dollar strength and intensifying competition. It is also expected to start reducing its debt to equity ratio and that should appease many big investors. However, given that it only needs to achieve a return on equity of around 14 per cent to justify our higher valuation.

While we are optimistic about its fundamental prospects, investing in ASL is not without risks.

That is why we are buying the stock at this price level - while it is trading at a discount of around 30 per cent to what we believe is its fair value.

Given the aforementioned risks, we think this is a sensible safety buffer.

For more risk tolerant investors who are prepared to ride out some volatility, this mining company represents a very fair risk/reward proposition and should form part of a well balanced portfolio.

Readers of Yahoo7 Finance can obtain a free 14-day trial offer of the MyClime online share valuation and research service at www.clime.com.au.

Investors should not rely on this information alone and should seek independent financial advice from a qualified expert before considering any share market investment. ++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.

Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.